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2 Degree of Master of International Studies (International Area Studies) Effects of the progressivity of the Income Tax on equity level. Case Latin America August, 2016 Development Cooperation Policy Program Graduate School of International Studies Seoul National University MIRNA NERY VÁSQUEZ PÉREZ

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4 Effects of the progressivity of the Income Tax on equity level. Case Latin America A thesis presented by MIRNA NERY VÁSQUEZ PÉREZ A dissertation submitted in partial fulfillment of the requirements for the degree of Master of International Studies Graduate School of International Studies Seoul National University Seoul, Korea August

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8 Abstract Effects of the progressivity of the Income Tax on equity level. Case Latin America Mirna Nery Vásquez Pérez International Area Studies Graduate School of International Studies Seoul National University In the last years Latin America has experienced economic and social changes; also fiscal policy has been affected for these changes. Some countries have enacted income tax reforms to achieve more equal tax systems, some reforms have aimed to make the statutory PIT rate schedule more progressive, but other countries have sacrificed the progressivity by simplifying the calculation of the tax, or to avoid the administrative burden associated with the collection of it, possibly due the constraints to control larger number of individuals by Tax Authorities. Top marginal tax rates for individuals and corporates have been changed during the last decades; some countries have equated the top marginal tax rates of individuals and corporates, while in other countries the tax rates are differentiated. Results show some countries have well income tax schedule design, but the larger number of deductions, exemptions, tax credits, and other prerogatives which mostly are targeted to higher income groups, erode the taxable income and make the income tax less progressive. i

9 Moreover, in some countries the various sources of exempt income or non-taxable income, exclude important tax revenues and make narrow tax bases; also the differentiation between marginal tax rates for wages earnings and marginal tax rates from capital income, or the elimination of latter income from the taxable income base, make the system more regressive. Results also showed that major differentiation on the progressivity of the design of the personal income tax schedule is by comparing the distance between the top and bottom marginal tax rate, among others. Simulation applied in Guatemala s case confirmed this result.. Keywords: Progressive taxes, Income Tax, Personal Income Tax, Tax schedule, Marginal Tax Rates, Tax System, Direct Taxes, Income Revenues, GDP per capita, Equity, Simulation, OECD countries, Latin American countries. ii

10 Table of Contents 1. Introduction Literature Review Progressive Taxation: Evidence from developed world Progressive Taxation: Evidence from Latin America Central American Countries Theoretical considerations of Progressive Taxation Methodological Aspects Aim of the Study and Research Questions Methodology Measuring progressivity of the PIT rate schedule Measuring impact of income tax reforms on equity Results Simulations Guatemala El Salvador Conclusions Appendix Countries simulation charts Guatemala El Salvador iii

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12 Introduction According to the International Monetary Fund Latin America still has the highest level of inequality in the world, and the advanced economies have the lowest 1, the factors involved in the high level of inequality are in certain point common for many Latin American countries, various countries have low levels of tax revenues collection and high demand of needs to cover for entire population. In the last years Latin America has experienced economic and social changes; also fiscal policy has been affected for these changes. Some countries have enacted income tax reforms to achieve more equal tax systems; some reforms aimed to make the statutory PIT rate schedule more progressive, but other countries have sacrificed progressivity by simplifying the calculation of the tax, or to avoid burden of the administrative process in the collection of it, possibly due the constraints to control larger number of individuals by Tax Authorities. Top marginal tax rates for individuals and corporates have been changed during the last decades; some countries have equated the top marginal tax rates of individuals and corporates, while in other countries the tax rates are differentiated. Results show some countries have well income tax schedule design, but the larger number of deductions, exemptions, tax credits, and other prerogatives which mostly are targeted to higher income groups, erode the taxable income and make the income tax less progressive. Also, in 1 IMF Fiscal Policy and income Inequality. Sound Policy Design: The Efficient Way to Cut Inequality. IMF Survey Magazine. 1

13 some countries the various sources of exempt income or non-taxable income, exclude important tax revenues and make narrow tax bases; also the differentiation between marginal tax rates for wages earnings and marginal tax rates from capital income, or the elimination of latter income from the taxable income base, make the system more regressive. Results also showed that major differentiation on the progressivity of the design of the personal income tax schedule is by comparing the distance between the tax rate of the first taxable income and the top marginal tax rate for the highest level of income, among others. Simulation applied in Guatemala s case confirmed this result. Another factor affecting the narrow tax bases, the lower levels of tax collection and the progressivity of the income tax is the scarce share of direct taxation represented by Personal or Corporate Income Tax, in contrast, the reliance on indirect taxation (value added tax or sale tax), main tax for all Latin American countries, has caused few room for the government to use tax policy as an instrument of equity. Therefore, this research seeks to add to previous empirical work for Latin America, an analysis of the effect of the progressivity of the income tax on equity, focused mostly on the analysis of the statutory PIT rate schedule, to determine if its whole design has been built in a progressive scale for each level of income, and also to examine if deductions, exemptions and other prerogatives can make the income tax more progressive, or conversely, it becomes regressive, and therefore this tax is contributing to the high rates of inequality in the region. 2

14 In addition, the study aims to provide a tool for policy makers to expand the income tax progressivity and improve equity, by conducting further research in the region, especially in Central American region, and thus, to widen the previous empirical work. This research tries to answer the following questions: 1) What countries have more progressive Income Tax? 2) Why in Latin American countries the Income Tax is less progressive? 3) Has progressive Income Tax had an impact on equity? For the above objective, Section 2 of this thesis presents different results of previous empirical studies on progressive taxation for developed world and Latin American countries, and theoretical considerations of progressive taxation. Section 3 contains the methodology, and the progressive personal income tax rate schedule measure used in this research. In Section 4 the results of the measure of the income tax schedules are presented. Section 5 describes the results of the simulations applied in two countries; and, finally, Section 6 the overall conclusions of this research. 3

15 Literature Review According to many researchers and empirical works through taxation, Governments can redistribute the income when this is unequal; national tax policies could use their room for progressive taxes to correct the disparities in the income distribution. By a Keynesian macroeconomic perspective, the redistribution may be systematically conducive to growth and employment, but some standards arguments against progressive taxation assert that taxes on top personal incomes and corporate income and wealth are detrimental on growth and employment, and then tax avoidance. Regarding to equity, for Perotti (1996) higher inequality leads to more redistribution and more taxation, inequality lowers the average level of income. More inequality, translates into higher demand for redistribution, but there is no evidence that higher income inequality leads to a higher level of redistributive taxation. 2 In fact, the most unequal countries tend to have lower taxes than in countries where income inequality is low. In a recent study by Godar, Paetz and Truger (2015), argues that even in the developed world, the trend of increasing inequality in the distribution of income and wealth has led to calls for increases of corrective taxes for the rich and wealthy. 3 In order to demonstrate that redistribution is generally accomplished by the use of progressive taxation, many studies for developed and developing countries have been practiced based on 2 Weil, David N Economic Growth, Third Edition, Pearson International Edition. P Godar, Paetz and Truger The scope for progressive tax reform in the OECD countries: A macroeconomic perspective with a case study for Germany. P. 2. 4

16 different data sources to assess the composition and relative reliance on different taxes. The studies have also examined the weight of direct and indirect taxes in the total tax revenues, and have analyzed what countries have more progressive income tax, and have found cross-country differences in the tax system. Consequently the following part will cover some empirical results focused on the income tax of those studies mainly from the developed world and Latin American countries. 2.1 Progressive Taxation: Evidence from developed world A research of Joumard, Isabelle, Mauro Pisu and Debbie Bloch, 2012 for OECD countries provides an assessment of the redistributive effect of the main taxes and cash transfers, based on various OECD data sources. The research pointed out, among other things, that in OECD countries high-tax countries tend to have less progressive household taxes, but progressive labor taxes due to earned income tax relief that has been raised to make work more attractive for lowincome earners. In addition, the study found that the decline in top marginal tax rates causes the PIT rate schedule became flat. The income tax is still considered the most progressive tax but there are significant cross-country variations, because in some countries is less progressive. Consumption taxes tend to be regressive in most countries. The taxation of capital income, wealth and 5

17 inheritance has been reduced in many countries, which has reduced the redistributive impact of tax systems. 4 In a publication of Eurostat 2014, assert that the EU remains a high tax area. In 2012, the tax level in the EU was high inclusive compared to other advanced economies; however, the publication asserts the weight of direct taxation is typically lower in the newer member states. The Member States which have joined the European Union from 2004 onwards have different structure compared with the EU The publication noted during 2008 and 2009, the fall in direct taxes was more pronounced than the fall in indirect taxes. Direct taxes have also taken longer to recover. The main components of direct taxes are taxes on the income of individuals and corporations. In the crisis, taxes on the income or profits of corporations experienced a decline in 2008 and further decreased in Despite their lower relative weight in the tax burden, the decrease in 2009 was stronger than the decrease in taxes on individual or household income (which are affected by unemployment). This reflects the higher sensitivity of corporate profits to the economic climate. The longer lag in recovery could also be partly due to taxation policies in many Member States allowing losses to be carried forward and offset against profits. 6 Since 2009, a number of Member States raised the top rate in the area of personal income taxation, and on the contrary, corporate income tax rates continued to decline after 2009, and there has been a broad trend to increase top PIT rates since Joumard, Isabelle, Pisu, Mauro and Bloch, Debbie (2012), Tackling income inequality: The role of taxes and transfers, OECD Journal: Economic Studies, published online first. P: 3. 5 Eurostat Edition. Taxation trends in the European Union Data for the EU Member States, Iceland and Norway. Taxation and Customs Union. P. 16, Eurostat Edition. Taxation trends in the European Union Data for the EU Member States, Iceland and Norway. Taxation and Customs Union. P. 18, 32. 6

18 In the North American region, an article written by Bird, Richard M. and Zolt, Eric M. 2015, examined the interaction of income inequality with tax and transfer systems in Canada and the United States, by comparing the data on taxation and expenditure and considered how changes to tax and transfer policies affected the levels of inequality in both countries. The study found that the United States can be more successful in using its tax system to reduce income inequality than Canada because of its heavy reliance on a relatively progressive personal income tax rather than taxes on consumption, while in Canada, changes are more likely to occur outside the tax system through such measures as minimum wage policy, improving access to early childhood education, or changing transfers financed more by increased consumption taxes. 7 In the case of the Asian region, a research done by Martínez-Vazquez, Jorge (2011), described for 2005 the composition or relative reliance on different taxes in Asia, finding that Asian region is quite different from that observed in other regions of the world. Direct taxes [personal income tax (PIT), corporate income tax (CIT), payroll, social security taxes, etc.] are larger than indirect taxes (value-added tax (VAT), sales tax, excises, foreign trade, etc.) in the world average by 50%, and in Organization for Economic Co-operation and Development (OECD) countries by over 100%. However, in Asia, indirect taxes dominate direct taxes by 10% (Martinez-Vazquez and Bird 2010) 8. The study found that the reasons explaining the difference in the above composition, is that personal income tax, payroll, and social security taxes are less important in Asian countries, 7 Bird, Richard M. and Zolt, Eric M. "Taxation and Inequality in Canada and the United States: Two Stories or One?." Osgoode Hall Law Journal 52.2 (2015) : Martínez-Vazquez, Jorge Taxation in Asia. Asian Development Bank. P. 4 7

19 while, taxes on foreign trade are significant, and from the middle of the eighties, the indirect domestic taxes have grown faster as share of GDP than direct taxes. In more recent research, Claus, Martinez-Vazquez, and Vulovic, 2012, assessed the impact of government fiscal policies on income inequality in Asia, panel estimation for 150 countries with data from 1970 to 2009 confirmed international empirical findings for Asia. Tax systems tend to be progressive, personal income taxes are more progressive in Asia than in the rest of the world, a possible explanation given by the study is that a large number of people not paying income tax, but nevertheless, corporate income taxes are less progressive due to larger tax incentives, exemptions, and concessions for Asian firms. The study asserts that tax systems in several Asian countries are characterized by relatively high tax rates and narrow bases, and a kind of reliance on corporate income taxation, which tends to be more distortionary (because of internationally mobile capital) than personal income taxation and VAT Progressive Taxation: Evidence from Latin America Research conducted by Cetrángolo and Gomez-Sabaini (2007) on direct taxation in Latin America, asserts that the situation regarding income tax in the region has two outstanding features, the low share of income taxes in the tax structure, and high tax shares of corporates versus income tax of individuals. 9 Claus, Martinez-Vazquez, and Vulovic. October Government Fiscal Policies and Redistribution in Asian Countries. No Asian Development Bank. ADB Economics Working Paper Series. P.32, 33. 8

20 The low importance of the income tax occurs in all countries of the region, where only three countries (Brazil, Colombia and Peru) managed to raise more than 6 percent of GDP from this tax in Moreover, the revenue from income tax in terms of GDP nearly doubled in Latin America in the last 15 years, from 2.1 percent of GDP in 1990 to 4.0 points in 2005, but these levels are still very low compared to international standards. 10 The study also notes that the main factors limiting the collection of the income tax are the reduction in nominal rates of income taxes, and limitations on the scope and coverage of income tax, for example the little strengthening the tax base, and its expansion. 11 In OECD publication of Tax Revenue Trends for Latin America and the Caribbean, asserts that revenues from incomes and profits grew in 4% of total tax revenues from 1990 to 2013, mostly for much higher collection levels in the late 2000s. Corporate income tax shares are still larger than personal income tax. The study added that that Latin America exhibit a relatively low direct-tax take counterbalanced by high indirect-tax receipts, taxes on goods and services make up about half of overall tax revenues, this greater reliance on indirect taxes may imply a more regressive tax system. 12 A study by Jiménez (2015) asserts that the possibilities of increasing the collection of personal income tax and expand its distributional impact in Latin America are conditioned by factors such as the top marginal rates are low, the behavior of legal aliquots, characterized by reduced 10 Cetrángolo and Gómez Sabaini La tributación directa en América Latina y los desafíos a la imposición sobre la renta. P. 48, Cetrángolo and Gómez Sabaini La tributación directa en América Latina y los desafíos a la imposición sobre la renta. P. 51, OECD Revenue Statistics in Latin America and the Caribbean 2015, Tax Revenue trends , OECD publishing. P. 24,25. 9

21 top marginal rate applied in the average of the country; the narrow tax base due to the existence of a high level of deductions or exemptions, that the assessment leaves out a significant amount of revenue, the narrow and the high rate of non-compliance (evasion and delinquency) seen in almost all countries, and tax administration issues Central American Countries In Central American region, Cubero and Hollar (2010) showed empirical evidence of integrated data on tax and expenditure from several studies in Central American countries (from the beginning of 2000), and also compared to other regions, results proved that Income taxes are generally progressive in Central America, and this is consistent with the evidence for developed and developing countries, and evidence suggest income taxes are much more progressive in Andean countries and in the United States. 14 The evidence also suggest income taxes can be much less progressive in some countries than in others, in part, this might reflect differences in economic structures across countries, but flaws in tax design likely also play a role. These flaws may simultaneously harm equity, efficiency, effectiveness, and administrative simplicity. For example, exemptions that disproportionately favor the richer segments of society may make the tax more regressive, facilitate evasion, and reduce revenue Jiménez, Juan Pablo Inequality, concentration income and taxation high incomes in Latin America. CEPAL. P. 28, Cubero, Rodrigo and Hollar, Ivanna. May Equity and Fiscal Policy: The Income Distribution Effects of Taxation and Social Spending in Central America. IMF Working Paper, WP/10/112: 14, Ibid, P

22 2.3 Theoretical considerations of Progressive Taxation Theory suggests that redistribution is generally accomplished by the use of progressive taxation; hence this section contains some theoretical considerations regarding this issue. The analysis of redistribution has change over time, in the past, it was based on the principles of benefit and ability-to-pay 16, these principles have been interpreted for some researchers to support progressive taxation, the benefit principle suggests that individuals and households with higher income and more wealth take advantage of the protections offered by the government, and therefore should have a higher tax burden; and the ability-to-pay principle based on the individual s ability to pay taxes. The above principles have been replaced with different models, of optimal progressivity, being the common between different models to concentrate on discovering the minimum efficiency cost of redistribution, tracing out the most efficient second-best outcomes for a given amount of redistribution. 17 And thus, the policy decision makers face dilemma between equity and efficiency, making it the core of problem of defining an optimal tax (Diamond Saez, 2011). Based on those analyses, tax policy design is largely influenced by the incidence of equity consideration, and its two main elements, horizontal equity proposes that taxpayers in similar circumstances should bear a similar tax burden, and vertical equity suggests that taxpayers in 16 Optimal progressivity. Working paper; Department of Economics, University of California (DEUCLA). P Ibid. P

23 better circumstances should bear a larger part of the tax burden as a proportion of their income. 18 For Diamond and Saez (2011) the fair distribution of the tax burden has long been a central issue in policy-making, a large academic literature has developed models of optimal tax theory to provide answers on the problem of optimal tax progressivity. 19 Regarding to progressive taxation, Conesa and Krueger (2005), suggest that progressive income taxes levied on the income of individuals and they play a potentially beneficial role in society, affecting consumption, savings and labor supply allocations across households and over time; they help to enhance a more equal distribution of income, and consequently, feasibly, wealth, consumption and welfare. 20 Diamond and Saez (2011) presents three policy recommendations for progressive taxes based on results in optimal tax theory: a) High earners should be subject to high and rising marginal tax rates on earnings, b) individuals from the poorest income groups should receive subsidies to complete the necessary income to survive, and, c) capital income should be taxed. 21 Another approach in an effort to set up an income tax with optimal progressivity is proposed by Mirrlees (1971), he found by numerical simulations that the optimal structure of any system of income taxes and transfers, are close to linearity of tax schedules, with tax rates below 40%, 18 OECD-ilibrary. Fundamental Principles of Taxation. Chapter 2. P Diamond, Peter, and Emmanuel Saez, The Case for a Progressive Tax: From Basic Research to Policy Recommendations. Journal of Economic Perspectives, 25 (4): Conesa and Krueger, On the Optimal Progressivity of the Income Tax Code. P Diamond & Saez (2011). The Case for a Progressive Tax: From Basic Research to Policy Recommendations. Cesifo Working Paper No P

24 mostly in the range of between 20% and 30%, and in the cases of calculated optimum schedules, the maximum marginal tax rate occurs at a rather low income level, and falls steadily thereafter. 22 The overall results of the Mirrlees model are, a) The marginal rate should be between zero and one, b) The marginal rate applicable to the person with the highest capacity must be zero, and, c) If the person with the lowest wage rate works in the optimal level, the marginal rate faced must also be zero. 23 In the Mirrlees model the problem of government is to choose a function that relates income after taxes, income before taxes, in order to maximize social welfare, but the government has budget constraints also cannot discriminate between types of individuals, so that only measures the individual income Mirrless, J.A. (1971). An exploration in the Theory of Optimum Income Taxation. P. 206, López, Salvador. Optimal Taxation: An introductory Panorama. Universidad Autónoma de Barcelona. P Ibid, P

25 Methodological Aspects 3.1 Aim of the Study and Research Questions The previous section focused on some empirical studies assessing the progressive taxation in the countries, the researches were based on various data sources, and the studies found countries with more progressive income taxes, or those that have proportional or regressive taxes. The studies also analyzed the source of total tax revenues collected, and showed cross-country differences in the tax systems. For instance, some data demonstrated that in OECD countries high-tax countries tend to have less progressive household taxes, but progressive labor taxes. In addition, the studies found that the decline in top marginal tax rates causes the PIT rate schedule became flat, the income tax is still considered more progressive, but less progressive for other countries; and consumption taxes tend to be regressive in most countries. The previous work also asserts that the tax level of the European Union is higher than other advanced economies, most EU-15 Member States, raise roughly equal shares of revenues from direct taxes, indirect taxes, and social contributions, but the weight of direct taxation is lower in the newer member states. In the case of United States, studies found heavy reliance on a relatively progressive personal income tax rather than taxes on consumption. For Asia region, some studies argued that tax systems tend to be progressive; personal income taxes are more progressive than corporate income, but the tax systems are characterized by relatively high tax rates and narrow bases, and a kind of reliance on corporate income taxation. 14

26 In the developing world, empirical work showed that the average tax burden on income and wealth for Latin America is accounted for lower amounts than OECD countries, but some individual countries were found in similar OECD level. Another research found that in six countries, revenue as a share of GDP has increased and experienced a significant rise in their tax revenues, but in contrast, the studies found Central American countries, that tax system is generally regressive. Having this overview of empirical work, this research seeks to add to previous empirical work for Latin America, an analysis of the effect of the progressivity of the income tax on equity, focused mostly on the analysis of the statutory PIT rate schedule, to determine if its whole design has been built in a progressive scale for each level of income, and also to examine if deductions, exemptions and other prerogatives can make the income tax more progressive, or conversely, it becomes regressive, and therefore this tax is contributing to the high rates of inequality in the region. In addition, the study aims to provide a tool for policy makers to expand the income tax progressivity and improve equity, by conducting further research in the region, especially in Central American region, and thus, to widen the previous empirical work. This research tries to answer the following questions: 1) What countries have more progressive Income Tax? 2) Why in Latin American countries the Income Tax is less progressive? 3) Has progressive Income Tax had an impact on equity? 15

27 The literature review pointed out that OECD countries have a better tax performance; high levels of tax burden, especially on income tax collection, which represent an important share in their total tax revenues collection, in most of them, taxes are progressive, in contrast, Latin American region shows a lower tax burden and volatile, the revenue as share of GDP is low, added to a low tax collection, their taxes are mostly regressive, and just some individual countries have showed a better performance in their total tax collection, but still the levels are quite distance from de developed world. Latin America is constantly designated by many studies of international institutions and researchers to be the most unequal region in the world, which contrasts with the amount of unmet demand and the lack of fiscal resources to meet them. The concentration of wealth is one of the reasons generally argued in relation to tax collection difficulties (Cetrángolo and Gómez- Sabaini, 2007). 3.2 Methodology An important factor contributing to the ineffectiveness of fiscal policy as a redistribution tool is the lack of progressivity in the income tax 25. Even though progressivity can be defined in different ways, for this paper a tax is progressive if the ratio of taxes to incomes rises as incomes rise, regressive if the ratio of taxes to incomes fall as incomes rise, or proportional if the ratio is the same at all income levels Mahon, Bergman, Arnson. Progressive Tax Reform and Equality in Latin America. Wilson Center P Congress of the United States. The Changing distribution of Federal Taxes: P

28 3.2.1 Measuring progressivity of the PIT rate schedule To examine if progressive income taxes are more related with developed world and have effects on equity, in contrast, Latin American countries mostly have less progressive income taxes; this paper focuses on examining the progressivity of the personal income tax based on statutory PIT rate schedule for Latin America and OECD s Central Government, which include: The progressivity of the statutory PIT rate schedule, The number and width of the tax brackets, Difference between the tax rates, Difference between the top and bottom marginal tax rate, Minimum non-taxable income, Marginal tax rates for each income level, Income needed to reach the bottom and top tax marginal tax rates. The analyzes of the personal income tax rate schedule for Latin America and OECD countries has been conducted from 2000, especially in the evolution in the number of thresholds, top and bottom marginal tax rates for each income tax bracket; the marginal tax rates for corporates, and the share of direct taxes (Individuals and Corporates Income Taxes) on total tax burden, among other issues, but the study is focused in 2013, which is the most recent year for which the information was updated and available at the time this paper was prepared, but also, along the document when appropriate, comments and analysis are made to other years. To measure progressivity of taxes this study uses data of Central Government Income tax Rates and thresholds from 2000 to 2013, for thirty four OECD members, and for eighteen Latin 17

29 American countries, but the analyses focuses in year 2013, this year was chosen considering the availability of data. National currencies of Latin America and OECD countries were converted to US dollars, and the theoretical tax units used by some South American countries (Chile, Venezuela, Colombia, Peru and Uruguay) also were converted to U.S. dollars to make the data comparable internationally. The data for OECD countries was mostly obtained from OECD Tax database, considering that the available information is internationally comparable. For Latin American countries, the data of general aliquots for individuals and Corporates income tax rates from 2000 to 2013 and its brackets were obtained from the Inter-American Center of Tax Administrations (CIAT), countries income tax legislation, and Official Fiscal Agencies websites. Per capita income and official exchange rates data were obtained from the World Bank Measuring impact of income tax reforms on equity In order to measure the impact of income tax reforms on equity, and considering that some countries have enacted income tax reforms in recent years, simulations were applied to Guatemala and El Salvador; these countries were selected bearing in mind the income tax reforms were strong in the case of Guatemala (considering the significant change in marginal rates and reduced deductions), and less strong for El Salvador (slight increase in deductions, and small change on the tax rate for the top income bracket), and the contrast of the tax reforms' impact on the different income levels. 18

30 Assumptions Simulations for Guatemala were applied for 2011, year before the income tax reform, and to 2013 after income tax reform, In the case of El Salvador, for 2010 and 2013 because it enacted its income tax reform in For both countries various annual income levels were measured (equivalent to different incomes per capita), mostly for wages earnings, similar to real wages of a private or public-sector worker, and took into account that taxable income fit in each income tax bracket, in order to measure the impact in the different marginal tax rates for each level of income, before and after reforms. It was considered the most frequent and important tax deductions, exemptions and credits that individuals usually deduce. In Guatemala s case, simulations considered the deduction of VAT credits and without VAT credits; the change of exempt income to taxable income, and increasing the marginal tax rates to levels before the reforms. In El Salvador s case, simulations considered dividends like taxable income and marginal rates as wage earnings. 19

31 Results Progressivity of the statutory PIT Rate Schedule The statutory Personal Income Tax schedules for most Latin American countries are built in a progressive scale, the lowest level of income has the lowest marginal tax rate, and by contrast, the top income level has, in most of the cases, the highest marginal tax rate, i.e, Table 1 shows the statutory tax rate schedule for Argentina and Brazil. Table 1 Progressivity of the Tax Rate Schedule Country Taxable Income (US$) Marginal Rate Argentina , % 1, , % 3, , % 5, , % 10, , % 16, , % 21, % Brazil , % 9, , % 14, , % 19, , % 23, % Source: Self elaboration based on CIAT, IBDF, PWC and countries legislation. 20

32 Number and width of the tax brackets The progressivity of the tax schedule depends on the number and width of the tax brackets 27 ; some countries aim to achieve more progressive income tax with opening more number of tax brackets, Ecuador has the largest number of tax brackets (9), followed by Venezuela, Mexico, and Chile (8); Uruguay and Argentina (7), most of the countries have 3 or 4 tax brackets, and Guatemala has the lowest number of tax brackets in the region, with just 2 (Table 2). Table 2 Latin America, Number of Tax Brackets, Guatemala Costa Rica Honduras Brazil Uruguay Venezuela Ecuador Panama El Salvador Nicaragua Argentina Mexico Paraguay Colombia Chile Peru Dominican Republic Source: Self elaboration based on CIAT, IBFD, PWC and Countries Legislation. Guatemala s Law for Tax Actualization (Decree ) included changes in the Income Tax; reforms implemented a dual-rate system with only two brackets of 5% for the bottom and 7% to the top, decreasing by 24 percentage points the maximum marginal rate from 31% to 7%, and also the bottom tax rate decreased from 15% to 5%. 27 Paturot, Mellbye and Brys Average Personal Income Tax Rate and Tax Wedge Progression and Tax Wedge. OECD. P

33 Trying to simplify the income tax calculation for individuals and firms, the reform eliminated many exemptions, and considerably reduced the tax credits of VAT which could be deducted from income tax before the reform, resulting in non-taxable income after doing this deduction, on which the tax could be applied, so income tax that could be determined was totally eliminated by the discount of the value of purchases from VAT. The new system promises to increase income tax revenues by eliminating the above exemption and others, but, still the income tax reform allow individuals and corporates to opt for the old system, but with a ceiling of credits that could be deducted. This issue is discussed in more detail in Guatemala s simulations. In the case of OECD countries, Luxembourg has the maximum number of thresholds of 19, followed by Switzerland (10), Spain, United States and Israel have 7 thresholds. Brazil had until 2008, 3 brackets, with bottom and top marginal tax rates of 15% and 27.50% respectively; in 2009 added two more brackets, increasing them from 3 to 5 with marginal tax rates from 7.50% to 27.50%; in the same year increased the minimum non-taxable income. Chile has 8 brackets since 2002, the bottom marginal tax rates was 5%, but in 2013 decreased in 4%; top marginal tax rate has been decreasing from 45% in 2000, 43% in 2002, 40% in 2003, an important aspect is that in 2013 all marginal tax rates for the thresholds were decreased, one percentage for the bottom, and around 2% percentage points for the next 5 thresholds, except the top marginal tax rate which remains in the same percentage of 40; fixing the rates from 4% for bottom level to 40% the top. 22

34 Ecuador increased from 6 brackets in 2007 to 9 in 2008, increasing by 10 points the top marginal rate from 25% to 35%; Honduras in 2009 decreased one threshold, and increased the minimum non-taxable income. El Salvador in 2011 embarked a major Income Tax Reform, increasing the minimum nontaxable in almost double amount, and the reform abolished the restriction that the resulting tax from individuals could not exceed 25% of its taxable income, which limited the progressive of the Tax (The top marginal tax rate for individuals was 30%); with this equates to the highest marginal tax rate of Corporates of 30%, and also, higher income groups may be taxed at a rate above 25%; the number of brackets remain since Until fiscal year 2011, the marginal tax rate applied to Corporates was a proportional tax rate of 25%, but Income Tax Reform of 2011 modified the system to two proportional rates: 25% for Corporates with taxable income up to US$150,000.00, and 30% for those with higher incomes to that amount. Mexico had in brackets, with lowest marginal tax rate of 3% and the top marginal rate in 40%; in 2002, it eliminated the last two highest marginal rates of 37.50% and 40% fixing the top marginal rate in 35% and 8 brackets. However, a year later eliminated the top marginal rate of 35%, and continued reducing the top marginal rates in the subsequent years, establishing in 2007 the top rate in 28% with only 5 brackets. In 2008 increased again to 8 brackets, however set the bottom marginal tax rate at 1.92% and the top marginal tax rate at 30%. 23

35 Thus, Mexico s highest income of $392, (US$30,758.08), according to PIT rate schedule in 2013, in year 2000 was subject to a marginal tax rate of 34%, same rate in 2002 and 2003; 33% in 2004, 30% in 2005, 29% in 2006, 28% from 2007 to 2009; and 30% since Nicaragua in 2000 had 5 thresholds with highest marginal rate of 25%, in 2004 increased the top marginal rate to 30%, and added one bracket (6 in total), but in 2013 reduced to 5 thresholds as in 2000, eliminated one marginal tax rate (10%), increased the minimum non-taxable, and fixed the highest marginal rate in 30%. Marginal tax rates fluctuate from 15% to 30%. Panama had 12 thresholds in 2000, the highest marginal tax rate was 30%; in 2005 had 6 thresholds and top marginal tax rate of 27%, and in 2010, 3 thresholds and marginal tax rates of 15% the lowest and 25% the highest. Paraguay until 2011 had no Income Tax, in 2013 has three thresholds, the bottom rate is 8% and the top is 10%. Peru since 2002 has 3 brackets, and since 2003 the bottom rate was set at 15% and the top 30%. Dominican Republic since 2000 has 4 income brackets, with bottom and top rates of 15% and 25% respectively, the Dominican government conducted annually adjusted for inflation. Argentina since 2000 has 7 thresholds with bottom and top rate of 9% and 35% respectively. Uruguay had no income tax until the middle of 2007 which came into force, since 2008 has 6 brackets with bottom and top rates of 10% and 25%, from 2012 has 7 thresholds, and the top rate is 30%. Venezuela since 2000 has 8 brackets with bottom and top marginal tax rates of 6% and 34% respectively. 24

36 In Chile, Colombia, Peru, Uruguay and Venezuela, the creation of the thresholds are based on Theoretical Units (UT, Unidades Tributarias, in Spanish) which purpose is to adjust the levels of the thresholds and tax payments to changes in the price level. Chile and Venezuela use Tax Units (UT); Colombia, Tax Value Unit (UVT); Peru, Tax Unit (UIT, Unidad Impositiva Tribtuaria); and Uruguay, Base of Benefits and Contributions (BPC). The following table shows the evolution in the number of thresholds for Latin American countries compared to OECD countries; it is observed OECD countries in average have more number of thresholds than Latin America, and Central American countries for years 2000 and 2006 surpassed Latin America average. 25

37 Table 3 Latin America, Evolution of number of Tax Brackets of Personal Income Tax Country Argentina Bolivia/ Brazil Chile Colombia Costa Rica Dominican Republic Ecuador El Salvador Guatemala Honduras Mexico Nicaragua Panama Paraguay/ Peru Uruguay/ Venezuela Latin America- Average Central America- Average OECD-Average Source: Self elaboration based on OECD-Statistics, CIAT, IBFD, PWC and countries legislation. Data extracted on 08 Oct :44 UTC (GMT) from OECD.Stat Data correspond to Central Government. 1/Bolivia has flat tax rate. 2,3/Paraguay's Income Tax Law took effect in 2012, and in Uruguay, in Table 4 measures the width of the tax brackets of Latin America countries. Mexico, Uruguay, Argentina, Chile and Ecuador are the countries with the wider tax brackets, measured by the distance between the top income level and the lowest taxable income according to the data held by the tax brackets. 26

38 Table 4 Width of Tax Brackets Difference Top Income Level and Lowest Taxable Income Country Relation Top Income Level/Lowest Taxable Income) Mexico Uruguay Argentina Chile Ecuador Venezuela 6.00 El Salvador 5.62 Nicaragua 5.00 Honduras 4.55 Panama 4.55 Colombia 3.76 Brazil 2.50 Dominican Republic 2.08 Peru 2.00 Costa Rica 1.50 Paraguay 1.11 Guatemala 1.00 Latin America- Average 9.14 Source: Self elaboration based on CIAT, IBFD, PWC and Countries Legislation. In OECD s case, United States, Germany, France, Korea, have the widest tax bracket, Spain, Israel, Switzerland and Portugal are above the OECD s average, but measured by the data contained in the tax bracket. 27

39 Table 5 Width of Tax Brackets Difference Top Income Level and Lowest Taxable Income Country Relation Top Income Level/Lowest Taxable Income) Mexico United States Germany France Korea Spain Israel Switzerland Portugal Australia 9.89 Japan 9.23 Luxembourg 8.88 Slovenia 8.84 Turkey 8.79 Finland 6.21 Austria 5.45 Chile 5.00 Italy 5.00 New Zealand 5.00 United Kingdom 4.69 Belgium 4.35 Canada 3.10 Iceland 3.06 Netherlands 2.85 Greece 1.68 Norway 1.63 Sweden 1.43 Denmark 1.00 Ireland 1.00 Poland 1.00 Slovak Republic 1.00 OECD-Average Source: OECD-Statistics. Tax Database. Data extracted on 08 Oct :44 UTC (GMT) from OECD.Stat Data correspond to Central government. It does not include Czech Republic, Estonia and Hungary w hich have flat tax rates. 28

40 Differences between the tax rates Regarding to the differences in the tax rates, Table 6 shows Colombia is the country with the highest marginal rate for the first taxable income bracket, 19% for an income of US$15,655.46, the average for Latin American countries is 10%. Mexico has the lowest income level and lowest marginal tax rate for the first taxable bracket of only 1.92%, Chile is the second with 4%, Ecuador and Guatemala have 5%. Table 6 also shows marked differences between Latin American countries, the lowest marginal tax rates fluctuated from 1.92% to 19%. Table 6 Lower Income and Bottom Marginal Tax Rate Country Lower Income Level (US$) Bottom Tax Rate (%) (First taxable bracket) Mexico % Chile 13, % Ecuador 10, % Guatemala 38, % Venezuela 17, % Brazil 9, % Paraguay 41, % Argentina 1, % Costa Rica 1, % El Salvador 4, % Uruguay 10, % Honduras 5, % Nicaragua 4, % Panama 11, % Peru 36, % Dominican Republic 9, % Colombia 15, % Latin America- Average 13, % Lowest bottom tax rate Highest bottom tax rate Source: Self elaboration based on CIAT, IBFD, PWC and Countries Legislation. By other hand, to examine the highest marginal tax rates for the top income level, Chile has the highest amount of 40%, the highest income groups in Chile are levied with higher marginal tax rate than Chilean Corporates (20%); Argentina and Ecuador have 35%, and highest marginal 29

41 tax rates ranging between 7% and 40%, Guatemala, Paraguay and Costa Rica have the lowest top marginal tax rate for the highest level of income. Table 7 Highest Income and Top Marginal Tax Rate g p g Country Highest Income Level (US$) Top Tax Rate (%) Chile 148, % Argentina 21, % Ecuador 103, % Venezuela 106, % Highest Marginal El Salvador 22, % Tax Rates Mexico 30, % Nicaragua 20, % Peru 73, % Uruguay 175, % Colombia 58, % Brazil 23, % Honduras 25, % Panama 50, % Dominican Repub 19, % Costa Rica 2, % Paraguay 46, % Guatemala 38, % Latin America- Average 56, % Source: Self elaboration based on CIAT, IBFD, PWC and Countries Legislation. A notable feature in Latin America is the income of wage earners is subject to withholding, so that it becomes more difficult to tax evasion committed, being the withholding agent responsible to pay the income tax to the Tax Authorities. Difference between the Top and Bottom Marginal Tax Rate 30

42 To examine the difference between the top marginal tax rate for the highest level of income and the tax rate of the first taxable income, provide a better idea of the progressive design of the tax schedule. Results showed that more progressive income taxes are in countries such as Chile with distance of 36%, Ecuador 30%, Mexico and Venezuela, 28%, Argentina 26%, Brazil, El Salvador and Uruguay, 20%, and countries with less progressive results are Nicaragua and Peru, 15%; Honduras, Panama and Dominican Republic, 10%, Colombia 9%, and the lowest amount is for Costa Rica, Guatemala and Paraguay, with percentage points of 5% and 2% respectively (Table 8, and Figure 1). Table 8 Difference between the Top and Bottom Marginal Tax Rates Country Difference Top and Bottom Tax Rate/1 Chile 36.00% Ecuador 30.00% Mexico 28.08% More progressive Venezuela 28.00% Argentina 26.00% Brazil 20.00% El Salvador 20.00% Uruguay 20.00% Nicaragua 15.00% Peru 15.00% Honduras 10.00% Panama 10.00% Less progressive Dominican Republic 10.00% Colombia 9.00% Costa Rica 5.00% Guatemala 2.00% Paraguay 2.00% Latin America- Average 16.83% Source: Self elaboration based on CIAT, IBFD, PWC and Countries Legislation. 1/ Bottom tax rate corresponds to the first taxable income. 31

43 It is observed than some individual countries show better tax threshold design, with notable distance between the bottom tax rate and the top, in the case of Central American countries, El Salvador shows a level of Brazil and Uruguay, this country embarked on fiscal reform in 2011, the effective marginal rate for the highest income was increased and eliminated legal restriction of the previous Income Tax Law which established a ceiling on the resulting tax could not exceed more than 25% of taxable income limited the progressivity of the tax, when the top marginal tax rate was 30%. Figure 1 Difference between the Top and Bottom Marginal Tax Rate, 2013 Source: Self elaboration based on CIAT, IBFD, PWC and Countries Tax Legislation. The bottom tax rate corresponds to the first taxable income In the case of OECD countries, the distance between the top and bottom tax rate is from 5% to 46.15%, of Sweden and Netherland respectively, the OECD average is 24.33%, most of OECD countries are above the average level (Table 9). 32

44 Table 9 Difference between the Top and Bottom Tax Rate Difference Country between the Top and Bottom Tax Rate/1 Netherlands 46.15% Germany/ % Israel 40.00% More progressive France 39.50% Chile 36.00% Japan 35.00% Slovenia 34.00% Portugal 33.50% Korea 32.00% Luxembourg 32.00% United States 29.60% Mexico 28.08% Australia 26.00% Finland 25.25% Belgium 25.00% United Kingdom 25.00% New Zealand 22.50% Ireland 21.00% Greece 20.00% Italy 20.00% Less progressive Turkey 20.00% Spain 17.75% Denmark 15.00% Poland 14.00% Canada 14.00% Austria 13.50% Switzerland 12.43% Norway 12.00% Iceland 8.90% Slovak Republic 6.00% Sweden 5.00% OECD-Average 24.33% Source: OECD-Statistics. Tax Database. Data extracted on 08 Oct :44 UTC (GMT) from OEC D.Stat Data correspond to Central government. It does not include Czech Republic, Estonia and Hungary which have flat tax rates. Data of Germany for the first brackets are not available due to income tax schedule is formula-based. 1/ Bottom tax rate corresponds to the first taxable income. 33

45 Figure 2 shows the evolution of the average bottom and top tax rates for Income tax of individuals, as it is shown in the figure along thirteen years the top tax rates of Latin American countries remain quite distant of OECD tax rates, and the bottom tax rates also are lower than OECD average. On average, Latin American countries have maintained the top tax rates in the past two decades, but in 2013 have been reduced in 2%, and the bottom tax rates has been fluctuated along the period of 2000 to In 2008 and 2009 experienced an increased of 14% similarly to the OECD countries bottom tax rate. By other hand, OECD countries have reduced in 4% the top tax rate from 40% to 36%, and in the years of global financial crisis decreased the top tax rates, whereas top tax rates of Latin America remain constant, this is due the crisis hit mostly the developed world. Figure 2 Evolution of bottom and top Income Tax Rates for Individuals Source:Self-elaboration based on OECD-Statistics, and CIAT, IBFD, Countries Legislation. Data refer to Central Government. Data extracted on 08 Oct :44 UTC (GMT) from OECD.Stat (For OECD countries) Bottom Marginal Tax Rate correspond to the first taxable bracket No data for Colombia for bottom tax rate in 2000 and 2005 Income Tax came into force in Uruguay in 2008, and for Paraguay in No available data for Germany bottom tax rate. 34

46 As it was mentioned in previous sections, some individual countries have shown a better performance in the progressive income tax design, Chile, Ecuador, Mexico, Argentina, Venezuela and Brazil, and even some international institutions have called them emerging markets, or transition economies, Figure 3, shows Chile overpassed the top tax rate of OECD average, and Argentina, Ecuador and Venezuela almost reach that level. Figure 3 Latin America: Bottom and Top Tax Rates for Individuals, 2013 Source: Self elaboration based on CIAT, IBFD, Countries Tax Legislation, for OECD countries based on OECD-Statistics. Data correspond to Central Government. Bottom Tax Rate correspond to first taxable bracket. Data extracted on 09 Oct :19 UTC (GMT) from OECD.Stat Chile, Ecuador, Colombia, Uruguay and Brazil have the peculiarity that top tax rate for individuals is higher than the tax rate for corporates, but in Chile the distance is much more marked, in the case of Chile the gap in tax rates was intended to create incentives for businesses to reinvest their profits and thereby contribute to economic growth and development Mahon, Bergman, Arnson. Progressive Tax Reform and Equality in Latin America. Wilson Center P. 32,

47 Latin American countries average is to equate both tax rates, while in Dominican Republic, Costa Rica, Bolivia and Guatemala corporates pay highest rates than Individuals, in Guatemala this difference is more noticeable (Figure 4). Meanwhile OECD countries taxed more individuals than corporates, 10% percentage points of difference. Figure 4 Top Marginal Tax Rates of Individuals and Corporates, 2013 Source: Self elaboration based on CIAT, IBFD, Countries Tax Legislation, for OECD countries based on OECD-Statistics. Data correspond to Central Government. Bottom Tax Rate correspond to first taxable bracket. Data extracted on 09 Oct :19 UTC (GMT) from OECD.Stat Paraguay, Brazil, Chile and Ecuador are the countries with the lowest tax rates for Corporates, Paraguay 10%, Brazil 15%, Chile 20% and Ecuador 22%. One of the important differences between the source of tax revenues for Latin American countries and the developed world is most of their total tax collected came from the income tax 36

48 paid by Corporates. The fewer individuals or taxpayers to be controlled by tax authorities and the larger size of each show that tax administrations have difficulties for the massive control of individuals, a fact that does not occur in developed countries. 29 Table 10 International Comparison of the Income Tax Structure, 2013 (As % of GDP) Country Corporates Individuals Total Corporates/ Individuals Income/ Consumption Chile Mexico Argentina Bolivia Brazil Colombia Costa Rica Dominican Republic El Salvador Guatemala Honduras Panama Paraguay Peru Uruguay Venezuela LatAm and the Caribbean-Average OECD-Average EU Japan Korea Canada United States Source: Self elaboration based on OECD Revenue Statistics. Data extracted on 03 Oct :48 UTC (GMT) from OECD.Stat Excluded Unallocable Individuals and Corporates. Table 10 shows for OECD countries and European Union, for every dollar collected of income tax from Individuals, 30 cents are collected from the income tax of Corporates, similarly, for 29 Cetrángolo and Gómez Sabaini Direct taxation in Latin America and the challenges in the income tax burden. CEPAL. P

49 Canada and the United States, 20 cents of Corporates for one dollar collected from individuals; however, for the average Latin American countries, for every dollar of income tax collected of individuals, it is collected about 2.5 dollar of income tax of Corporates. Some countries try to balance the tax burden of individual taxpayers and Corporates, but wage earnings are subject to withholding in the source is more difficult for people to avoid the tax payment, but high income individuals receive that income from capital gains, some of these revenues are not subject of withholding in the source, so this income is more prospective to evade tax payments. It must be noted that in Uruguay, Peru, El Salvador, Guatemala, Honduras, Nicaragua and Panama, capital income (interest, profits, dividends, rents, capital gains) are taxed at proportional tax rate, Uruguay top tax rate is 12%, Honduras, Nicaragua, Panama, 10%; El Salvador and Guatemala from 5% to 10%, and Peru between 4.1% to Figure 5 Top Tax Rates for Type of Income Source: Self elaboration based on CIAT, IBFD, Countries Tax Legislation. Data of Top Tax for capital income based on Garcimartín, Diaz de Sarralde, Garcimartín, Diaz de Sarralde Analysis of the tax system in Dominican Republic. P

50 Minimum non-taxable Income Twelve of seventeen Latin American countries have minimum non-taxable income in the PIT schedule design, except Argentina, Guatemala, Mexico, Peru and Venezuela, the highest minimum non-taxable income belong to Paraguay, followed by Colombia, Chile, Panama, Uruguay and Ecuador, these countries share the characteristic that derive income from non-tax sources, by the exploitation of natural resources. This is probably by the fact that some countries allow the deduction of fixed amounts during the computation of the taxable income, as in the case of Guatemala, Mexico and other countries. In the case of OECD countries eight of thirty four countries have minimum non-taxable income in the PIT schedule design, the rest of countries levied marginal income tax from the first bracket. Top Marginal Tax Rate for Income Level Another way to measure the progressivity of the tax schedule is through the comparison of the income per capita for each income interval. To examine the top marginal tax rates in every country, results summarized in Table 11 shows Argentina and Mexico have the highest marginal tax rates for one income per capita, 27% and 21.36% respectively, whereas in nine of eighteen countries, one per capita income is not taxed, in the rest of the countries, the top marginal tax rate range between 4% and 15%. Argentina, Colombia and Costa Rica levied the highest marginal tax rate since two incomes per capita; Mexico has the third position after Argentina and Colombia to levy with higher marginal 39

51 tax rate, two per capita incomes, but does not impose its highest marginal tax rate of 30%, whereas Ecuador, Honduras, Nicaragua, Paraguay and Peru even for 10 incomes per capita do not tax to their highest marginal tax rate. Only in Paraguay, Honduras and Nicaragua to obtain two incomes per capita is not taxed, and as stated above, some countries taxed from this income interval to its highest marginal rate; Venezuela, Ecuador and Guatemala taxed this interval with low marginal tax rate; Bolivia and El Salvador taxed below the Latin American average. It must be noted that Law on Income Tax in Paraguay came into force until Ten of the eighteen countries levied below Latin America average, three per capita incomes; and for five per capita incomes, most countries are above the average for Latin America, and the same pattern is displayed to ten per capita incomes. Paraguay and Guatemala have the lowest marginal tax rate for 10 incomes per capita rate, this is due to their highest marginal tax rate correspond to the lowest in Latin America, in the case of Paraguay even for 10 per capita incomes does not levy its highest marginal tax rate of 10%, probably because the State receives revenue from the trade of electricity, but in the case of Guatemala, it does not have many sources of revenue from natural resources. It must be noted that Bolivia applies fixed tax rate of 13% for different levels of income, in this country like Paraguay, many of the sources of revenue come from natural resources, and these are held by the State, which allows not rely on tax revenue sources. 40

52 Country Table 11 Top Marginal Tax Rate for Income Level, 2013 Income per capita US$ 1 Y Per 2 Y Per 3 Y Per 5 Y Per 10 Y Per Top Marginal Tax Rate (%) Top Marginal Tax Rate (%) Top Marginal Tax Rate (%) Top Marginal Tax Rate (%) Top Marginal Tax Rate (%) Argentina 14, % 35.00% 35.00% 35.00% 35.00% Bolivia 2, % 13.00% 13.00% 13.00% 13.00% Brazil 11, % 22.50% 27.50% 27.50% 27.50% Chile 15, % 19.00% 19.00% 23.00% 40.00% Colombia 8, % 28.00% 28.00% 28.00% 28.00% Costa Rica 10, % 15.00% 15.00% 15.00% 15.00% Dominican Republic 5, % 15.00% 20.00% 25.00% 25.00% Ecuador 6, % 5.00% 12.00% 15.00% 25.00% El Salvador 3, % 10.00% 20.00% 20.00% 30.00% Guatemala 3, % 5.00% 5.00% 5.00% 7.00% Honduras 2, % 0.00% 15.00% 20.00% 20.00% Mexico 10, % 23.52% 23.52% 30.00% 30.00% Nicaragua 1, % 0.00% 15.00% 20.00% 25.00% Panama 11, % 15.00% 15.00% 25.00% 25.00% Paraguay 4, % 0.00% 0.00% 0.00% 8.00% Peru 6, % 15.00% 15.00% 15.00% 21.00% Uruguay 16, % 20.00% 20.00% 22.00% 30.00% Venezuela 12, % 9.00% 16.00% 24.00% 34.00% Latin America-Average 6.88% 13.89% 17.45% 20.14% 24.36% Source: Self elaboration based on CIAT, IBFD, Countries Legislation, and World Bank for per capita income. Data correspond to Central Government. Figure 6 shows the comparison for five different level of income per capita of Latin American countries, Central American region, and OECD countries, it is observed that the lowest average of marginal tax rates for level of income is focused in Central America, Latin America average of marginal tax rates for all levels of income is quite distant from the developed world, for 10 incomes per capita is 24.36%, around 13% points below of OECD countries. 41

53 Figure 6 Top Marginal Tax Rate for Income Level Source: Self elaboration based on CIAT, IBFD, Countries Legislation, and World Bank for per capita income. Data correspond to Central Government. No available data for Germany bottom tax rate. The above results are consistent with the results of Table 12, of the income needed to reach the top and bottom tax rates of personal income in number of times GDP per capita. Income needed to reach the bottom and top marginal tax rates For Latin American countries to meet the bottom tax level in the tax brackets is in average 2.33 times the GDP countries per capita, while for OECD countries take just 0.65 times, and to reach the top level of the income bracket, Latin America takes 7.11 times the GDP per capita, whereas for OECD countries, 3.73 times, this means to start to tax the first income bracket is more distant for Latin America, but some countries show pattern similar to some OECD countries; and same pattern, to tax with the highest marginal tax rate the highest level of income (Tables 12 and 13). 42

54 Table 12 Income needed to reach the bottom and top tax rates of Personal Income (In number of times per capita income), 2013 Number of times the GDP per capita to Country which it applies (US$) Bottom Tax Rate Level Top Tax Rate Level Argentina Bolivia Brazil Chile Colombia Costa Rica Ecuador El Salvador Guatemala Honduras Mexico Nicaragua Panama Paraguay Peru Dominican Republic Uruguay Venezuela Latin America-Average OECD-Average Source: Self elaboration based on CIAT, World Bank for GDP per capita and official exchange rates, and official Tax Offices websites. Data extracted on 08 Oct :44 UTC (GMT) from OECD.Stat Domestic currency for El Salvador, Ecuador and Panama is US$ Honduras, exchange rate correspond to The values of the Tax Units of Chile, Colombia, Peru, Uruguay and Venezuela were converted to local currency, based on data of official Tax Offices websites Bolivia has flat tax rate 43

55 Table 13 Income needed to reach the bottom and top tax rates of Personal Income (In number of times per capita income), 2013 Number of times the GDP per capita to Country which it applies (US$) Bottom Tax Rate Level Top Tax Rate Level Australia Austria Belgium Canada Chile Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Israel Italy Japan Korea Luxembourg Mexico Netherlands New Zealand Norway Poland Portugal Slovak Republic Slovenia Spain Sweden Switzerland Turkey United Kingdom United States OECD-Average Source: Self elaboration based on OECD-Statistics, CIAT, World Bank for GDP per capita and official exchange rates, and official Tax Offices websites. Data extracted on 08 Oct :44 UTC (GMT) from OECD.Stat The German personal income tax schedule is formula-based. Czech Republic, Estonia and Hungary have flat tax. 44

56 SUMMARY OF RESULTS What countries have more progressive Income Tax? Progressive Measure Results showed that more progressive income taxes are in countries such as Chile with distance of 36%, Ecuador 30%, Mexico and Venezuela, 28%, Argentina 26%, Brazil, El Salvador and Uruguay, 20%, and countries with less progressive results are Nicaragua and Peru, 15%; Honduras, Panama and Dominican Republic, 10%, Colombia 9%, and the lowest amount is for Costa Rica, Guatemala and Paraguay, with percentage points of 5% and 2% respectively, analyzed by the progressivity of the statutory PIT rate schedule, more specifically by the difference between the top and bottom marginal tax rate. Table 14 Difference Top Marginal Tax Rate and First Taxable Income Tax Rate 45

57 Results showed the difference between the highest marginal tax rates paid by higher income groups is quite similar to the lowest marginal tax rate paid by lowest income groups, making the income tax clearly less progressive. Top Marginal Tax Rate for Income Level The following Latin American countries were found for each level of income per capita below the Latin America average, four of five Central American countries; and Venezuela, Peru, Paraguay and Bolivia. Some of these countries also were found in the results of the above cited progressive measure. Table 15 Top Marginal Tax Rates for Income Level, 2013 Country 1 Y Per 2 Y Per 3 Y Per 5 Y Per 10 Y Per Income per Top Marginal Top Marginal Top Marginal Top Marginal Top Marginal capita US$ Tax Rate (%) Tax Rate (%) Tax Rate (%) Tax Rate (%) Tax Rate (%) Venezuela 12, % 9.00% 16.00% 24.00% 34.00% Costa Rica 10, % 15.00% 15.00% 15.00% 15.00% Peru 6, % 15.00% 15.00% 15.00% 21.00% Ecuador 6, % 5.00% 12.00% 15.00% 25.00% Paraguay 4, % 0.00% 0.00% 0.00% 8.00% El Salvador 3, % 10.00% 20.00% 20.00% 30.00% Guatemala 3, % 5.00% 5.00% 5.00% 7.00% Bolivia 2, % 13.00% 13.00% 13.00% 13.00% Honduras 2, % 0.00% 15.00% 20.00% 20.00% Nicaragua 1, % 0.00% 15.00% 20.00% 25.00% Latin America-Average 6.88% 13.89% 17.45% 20.14% 24.36% Source: Self elaboration based on CIAT, IBFD, Countries Legislation, and World Bank for per capita income. Data correspond to Central Government. Bold numbers correspond to the values that exceed the average. One possible explanation is that by not imposing the tax burden on one income per capita, the countries are leaving out a significant amount of potential taxpayers. But probably the country aims to release the tax burden to the lowest income groups, as in the case of El Salvador, the reform of income tax that took effect in 2011 had aim apart from simplifying the process, 46

58 release the burden to the first taxable bracket which corresponded to the lower income groups, for wage earnings equivalent to two monthly minimum wages (US$242.40) 31. To fulfill this goal, monthly computation of taxable income tables were changed, so the tax withholding by the employer would correspond to the tax payment, in which case, taxpayers were not required to submit the annual tax form, and the Fiscal entity released the administrative burden involved of receiving thousands of income tax forms. The Income Tax Reform launched by Guatemala had similar goal, besides of simplify the income tax calculation, the reform increased the amount of fixed deduction which not required support documentation of US$6,109.20; with this amount the lowest income groups do not compute taxable income and thus do not pay the tax. Why in Latin American countries the Income Tax is less progressive? Latin American Tax System, the Role of Direct Taxation and Income Tax. Lowest Level of Tax Burden as Percentage of GDP Comparing the tax burden of Latin America region with the developed world (Figure 7), tax revenues is quite distant of total tax revenue level of the developed world (European Union 31 Ministry of Labour of El Salvador, Minimum Wage Table. 47

59 members, OECD countries, U.S., Japan). Even, middle income countries in Africa (2010) have a level of tax burden around 26.7% of GDP, and 20.3% for total Africa. 32 Even though Latin America region has experienced an increase of the ratio of tax revenue to GDP, from 14.4% in 1990 to 21.3% en 2013 (Appendix Tables A and B), examining the tax burden average between the last two decades, it is observed that all the countries, with Venezuela as exclusion, probably by the fact that it has other sources of non-tax revenue, increased the tax burden levels, even Central American countries. But while Brazil, Uruguay, Venezuela and Chile since 1990 reached the level of total tax revenue above 17% of GDP, in the case of Central American countries, except Costa Rica has not reached in 2013 a ratio of 20% of GDP Tax revenues, other non-central american countries have not reached also the 20% of GDP, these countries are, Mexico, Dominican Republic, Ecuador, Paraguay, Peru, and Venezuela (Appendix Table A). Countries with the lowest level of Tax Burden as percentage of GDP below the Latin America average are, Central American countries, and Peru, Ecuador, Mexico, Colombia and Chile, but Colombia and Chile have a tax burden a slightly above 20% of GDP whereas the rest of the countries are below that level. Guatemala has the lowest level of tax burden and Brazil has the highest with level above the OECD average. Argentina, Bolivia, Uruguay and Costa Rica have the tax burden above the Latin America average (Figure 7). 32 African Economic Outlook OECD. Chapter 2. Figure

60 In the OECD Economic Outlook report, asserts that countries in the Latin American region need to strengthen their financial and fiscal framework by expanding their fiscal space, especially Central American, Andean countries and Mexico. 33 Paraguay, El Salvador, Venezuela, Dominican Republic and Guatemala have the tax burden even below Central America average. Figure 7 Latin America and Other regions: International Comparison of the Tax Burden, 2013 (As percentage of GDP) Source: Self elaboration based on OECD Statistics. Data refers to Total Government. Data extracted on 26 Sep :08 UTC (GMT) from OECD.Stat Central America Average1 = Includes Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama. OECD = The OECD average for 2013 was calculated with available data of 31 countries for that year. EU21 = Austria, Belgium, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxembourg, the Netherlands, Poland, Portugal, Slovenia, the Slovak Republic, Spain, Sweden and the United Kingdom. Low shares of Direct Taxes and Income Tax The Latin America s share of direct taxation (income tax, property, payroll) excluding social contribution, that are characterized by progressive or proportional, represent a small share of total tax revenues as percentage of GDP, (6.5%), whereas the levels of indirect taxation (10.6%) 33 OECD Economic Outlook: Projections for Latin American countries*. June P.8 49

61 this share of indirect taxation is almost in the same level of the OECD countries (11%), and the European Union members (12%). The unbalanced tax structure biased in favor of indirect taxes, diminish the redistributive effect of the tax system, and this make a regressive tax structure in many countries in the region 34. Even though the gap of direct taxation remains large compared to indirect taxation, some countries have improved the levels, Brazil has the highest level, followed by Colombia, Argentina, Uruguay, and Chile, the rest remains quite distant of reach a high level of direct taxation, and Guatemala and Paraguay have the lowest level in the region. (Figure 8) Figure 8 Direct and Indirect Taxes as Percentage of GDP, 2013 Without Social Security Contributions Direct Taxes Indirect Taxes Source: Self elaboration based on OECD Statistics. Revenue Statistics-Latin American countries. Data extracted on 26 Sep :08 UTC (GMT) from OECD.Stat Direct Taxes include: Income, profits and capital gains, payroll and property. Indirect Taxes: Goods and Services. Data refers to Total Government. EU21 = It represents a group of 21 countries of European Union: Austria, Belgium, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxembourg, the Netherlands, Poland, Portugal, Slovenia, the Slovak Republic, Spain, Sweden and the United Kingdom. 34 Gómez Sabaini and Jiménez Tax Structure and Tax Evasion in Latin America. CEPAL. P

62 Some researchers assert that low direct taxation is due the complexity in terms of its administration and administrative costs involved, the levels of evasion, the result of having other sources of income, historical aspects, or the colonial past in some Latin American countries which is still evident through low taxation of wealth (income tax, property, and other forms of direct taxation). -Income Tax as Percentage of Total Tax Revenue The share of the income tax in total tax revenue of Latin America represents in 2013 on average 26.7% compared with 33.9% for OECD countries. Countries with the lower Latin America average are, Dominican Republic, Uruguay, Ecuador, Brazil, Costa Rica, Argentina, Paraguay and Bolivia. (Appendix Table A) For some countries such as Peru, Chile, Colombia, Mexico and El Salvador, the tax collection by income tax represents more than 30% of the total tax revenues, almost 40% for Peru, but for Paraguay, Argentina and Costa Rica account for less than 20% of total tax collection. According to the Ministry of Economy and Public Finance of Argentina, Argentina s income tax collection of 2013 increased compared to 2012 due to higher revenues by withholdings regimes, increase in the level of economic activity, prices, wages, imports, and legal changes affecting these regimes, but the positive effects were reduced by the raise of personal allowances for certain levels of income in this tax Ministry of Economy and Public Finance of Argentina. Revenue Report, fourth quarter 2013 and P.2,14. 51

63 In Peru the revenue from the income tax declined compared with 2012, mainly explained by lower payments of income tax in the third category due to the unfavorable external environment, which affected the primary sectors, but other components of income tax increased the payments, the increase in payments for labor income (fourth and fifth categories), was consistent with the favorable performance that had formal employment in 2013 as well as the behavior of the average income. 36 By contrast, taxes on goods and services (Sale, Value Added Tax, Excises) contribute more than a half ot total tax revenues for the Latin region, around 14% points more than OECD countries and the European Union (Appendix Table A). -Income Tax as Percentage of GDP The income tax in the Latin American region, in 2013 has ranged between 2.5% and 7.4% of GDP, correspond to Paraguay and Brazil respectively, and along the period 1990 to 2013 has increased almost 2% of GDP, this is positive and reflects a major concern of countries in its strengthening. The share of income tax in total revenue has also increased from 23% to more than 26%, from 1990 to (Appendix Table A and Figure 9) The tax levied by Income tax for 2013 account for only 6.2% of GDP, contrasting with the OECD countries in which taxes on personal and corporate incomes remain the most important source of revenues, for instance, for Denmark represents around 31% of GDP, and for Norway, New Zealand, Iceland, Finland and Belgium more than 15% of GDP; and if measured as percentage of total tax revenue, for Iceland, Norway, Canada, United States, Ireland and 36 Nota de Prensa N SUNAT, Peru. P. 1,4. 52

64 Switzerland the share of income tax account for more than 40%, and for Denmark and New Zealand for more than 50%. 37 The below figure shows the increasing trend in the share of income tax in the last two decades compared with taxes on goods and services (indirect taxes) and total tax revenues. Figure 9 Latin America: Tax Revenues, Source: Self elaboration based on OECD Statistics. Data extracted on 06 Oct :26 UTC (GMT) from OECD.Stat 37 OECD-Revenue Statistics. Comparative Tables, data extracted on 03 October

65 Simulations 5.1 Guatemala To provide an answer if progressive Income Tax has had an impact on equity, simulations applied to compute the income tax for individuals in Guatemala, analyzed the effects in different income levels the Income Tax schedule for individuals before and after income tax reform that took effect in this country in 2012, by Decree Results showed the income tax reform has favored higher income groups. Before the income tax reform, an annual wage of US$120, (equivalent to 35 incomes per capita) paid an amount of US$12,468.20, while after the income tax reform; same amount pays only US$6, paying the half amount than before the income tax reform. Table 16 Guatemala Income Tax computation for Individuals, Different Income Levels Before and After Income Tax Reform (In US$ dollars) Income Level 6, , , , , Incomes Per 5-6 Incomes Per Incomes Per Incomes Per Incomes Per Before Income Tax Reform ( A ) , , After Income Tax Reform ( B ) , , , Difference ( B - A ) , Change ( B / A ) Source: Income Tax Law of Guatemala, Decree No , Decree No ; Social Security Law. World Bank for GDP per capita and official exchange rates. Assumption: 2011 year before reform; 2013 after reform. Official Exchange rate of 2011: US$7.785; 2013: US.$ GDP per capita 2011= US$3,166.59; 2013= US$3,

66 For annual wage earnings of US$48,000.00, the difference in the income tax computed after reform is also lower, than before income tax reform. By other hand, lower income levels, from 5 to 11 incomes per capita, approximately, for annual wage earnings of US$18, and US$36,000.00, the computed income tax is higher after reforms than before. And, for an annual wage of US$6,000 (From 1 to 2 incomes per capita); this level of income does not pay before reform, and after reform. It seems to be, the tax burden falls on the middle income level. Explanations of these results could be Guatemala's Income Tax Law allowed numerous tax deductions, exemptions and benefits which significantly reduced the progressivity of the tax, since these deductions, exemptions and benefits eroded the taxable income base, and above all, if the deductions are aimed to favor higher income sectors. The following table shows some of the common income tax deductions to compute the income tax for individuals; these deductions were contained in Decree before Income Tax Reform. 55

67 Table 17 Guatemala s Income Tax Law, Decree Exemptions, Deductions and Credits Exempt Income Bono 14 (Annual Bonus) Christmas box [100% of monthly wage, (Public and Private Sector] Incentive Bonus (Decree ) Deductions Minimum Vital [Not required support documentation, Art. 37] (Q. 36,000.00; US$4,624.28) Social Security Contributions (4.83% of income) Other pension plans Insurance premiums: Life, accident and medical expenses Medical, hospital and laboratory costs Alimony fees set by Family Courts (Not exceed US$1,284.52) Donations (Not exceed more than 5% of net income, or maximum amount of US$64, annually) Other Expenses (Surety bond premiums, professional tuition, etc.) Value Added Tax Credit (12% of Net Income) Source: Income Tax Law of Guatemala, Decree No Art. 6, 37, and 37."A", Decree Guatemala s Income Tax Law allowed deductions from taxable income, an amount of US$4, (Official exchange rate of 2010, US$7.785); according to article 37 of the Income Tax Law, this deduction did not require the submission of any document to prove the expenditures. The Decree also allowed the deduction of some expenses without amount restriction, for instance, medical, hospital and laboratory costs, these expenses could come from the taxpayer s spouse and children. 56

68 This deduction seems to benefit higher income groups due to the higher income levels can afford to pay higher fees in these concepts rather than lower income groups. After the income tax reform, the Tax Authority reduced the deductions as follows: Table 18 Guatemala s Income Tax Law, Decree Exemptions, Deductions and Credits Exempt Income Bono 14 (Annual Bonus) Christmas box [100% of monthly wage, (Public and Private Sector] Incentive Bonus (Decree ) Deductions Minimum Vital [Not required support documentation, Art. 72] (Q. 48,000, US$6,109.20) Social Security Contributions (4.83% of income) Other pension plans Life Insurance premiums Donations (Not exceed more than 5% of gross income) Other deductions (Value Added Tax Credit, Top US$1,527.30) Source: Income Tax Law of Guatemala, Decree No Art. 70, 72, Decree No Even though most deductions were cut, the deduction of personal allowance, for which no supporting documentation is required, increased from Q. 36, to Q. 48,000.00, increasing the amount in almost US$1, (Official exchange rate 2013, US$7.857). One of the deductions that draw attention is the deduction of tax credit of VAT from the taxable income, Art. 37. A (Decree 26-92), before income tax reform, it was allowed the deduction of the value added tax paid on the acquisition of goods and services during the liquidation period of the annual tax for the use of the taxpayer and his family, up to an amount equivalent to the tax rate of value added tax (12%) applied to net income earned in that period. 57

69 If this credit exceeded the income tax payable, the excess would not generate right to any refund. The appropriation of this deduction was verified by submitting a form containing the details of the bills or tickets, which were later subject to verification by the Tax Authority. 38 Article 13 of Income Tax Regulation, established the requirements to register in the tax system the data to be allowed the return for credit for Value Added Tax (VAT), the information might contain: 1) Identification of the taxpayer: a) Full name. b) Tax Identification Number (TIN), and c) Period of annual final settlement. 2) Employer Identification: a) Full name, if an individual: or company name, if a legal person, and, b) Tax Identification Number (TIN). 3) Invoices and tickets description. 4) Full name, corporate name of the issuer (seller) for incorporation in the invoice or ticket. 5) Tax Identification Number (TIN) of the issuer (seller). 6) Date of issue and serial number of the invoice or ticket. 7) Description of the goods and services purchased. 8) Total value of purchases by invoice or ticket, which already include value added tax (VAT). 9) Total purchases taxed by the value added tax (VAT) made during the annual final settlement of the taxpayer. 38 Guatemala s Income Tax Law. Decree 26-92, Article 37. A. 58

70 10) Total Value Added Tax (VAT) paid by the taxpayer during the annual final settlement. 39 Even this regulation allowed the deduction of VAT for the purchase of houses, allowing the deduction of the total payment during the period of income tax annual liquidation, either if the purchase had been done by cash or by installments according to invoices or deed, so that, indiscriminately allowed the complete elimination of the tax on the resulting income. Besides, all taxpayers were required to keep the invoices and tickets that had served as the basis for calculating the value-added tax credit, until the prescription period. This deduction was clearly regressive since higher income groups could afford to spend more money in consumption rather than lower income groups. Higher income levels benefited with this deduction, before Income Tax reform, due to more purchasing capacity, rather than lower income groups. It was much easier for higher income groups to remove the resulting income tax at the end of the year, than lower income groups by purchasing more goods or services to eliminate the income tax. Regarding to this, a study by Jimenez Gomez Sabaini and Podesta (2010) limited on a sample of seven Latin America countries, estimated the income tax rates of evasion for individuals and 39 Income Tax Law Regulation of Guatemala. Governmental Agreement No , August

71 corporates, and found in six of seven countries the coefficients for the tax paid on individuals were lower than the income tax for corporations, just Guatemala showed opposite results. 40 Probably the results of the study were due the aspects mentioned in this section. Figure 10 Estimated Tax Evasion on Income Tax in selected countries (In percentage rate) Source: Jiménez, Gómez Sabaini y Podestá (2010) After the income tax reform, the Tax Authority reduced the VAT credits for fixed amount of Q.12, (US1,527.30, official exchange rate of 2013; US$7.857), (Art. 72, Decree ). The following table shows comparison of the Value Added Tax credit from different income levels, it is noted that before income tax reform higher income levels benefited the most from 40 Gómez Sabaini and Morán Tax policy in Latin America: an agenda for a second generation reform. CEPAL. P